Feature

New Life for the Old World

Europe's fortunes decoupled from America's soon after the financial crisis of 2008, as the ECB dithered. Now, the continent's stocks are set to climb nearly 10%. Best bets: Poland and European bank stocks.

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Europe's failure to craft a swift response to the financial crisis delayed the rebound in the Continent's stocks, and although conditions for a sustained rally are improving, it will be years before markets scale new heights.

European and U.S. equities touched their post-2007 lows on the same date—March 9, 2009—but their fortunes decoupled shortly after. Decisive action by the Federal Reserve through quantitative easing paved the way for U.S. stocks to bounce back quickly, while the European Central Bank dithered. That hesitation has proved costly: At a time when the Dow Jones Industrial Average is reaching a new peak, the Stoxx Europe 600 index languishes about 40% below its all-time high.

It took the ECB three years to deliver a decisive blow to the gloom. In the summer of 2012, ECB President Mario Draghi pledged to do "whatever it takes" to defend the euro, halting what had seemed like the terminal erosion of investor confidence in the euro zone and hushing breakup talk.

The relief among investors was almost instant. Markets in Europe have been on a hot streak since Draghi delivered his remarks, with the Stoxx Europe 600 index adding about 13% since late July, compared with 9% for the Dow Jones Industrial Average and 18% for Asian stocks, as measured by the MSCI AC Asia Index. Europe's markets have paused for breath after a positive start to 2013, but rather than shaking investors' faith, the lull is reinforcing it: The pullback offers investors who missed the initial run-up the chance to get involved. European stocks can climb more than 9% this year, analysts say. They're up 3.3% already.

"I think we are in the early stages of the healing process where risk is coming back into equities," says Andrew Slimmon, managing director of global investment solutions at Morgan Stanley in Chicago.

Europe looks cheap compared with the U.S., and in line with Asia. The Stoxx Europe 600 trades at 12.4 times estimated 2013 earnings and 11 times forecast earnings for 2014. The S&P 500 fetches price-to-earnings multiples of 13.7 and 12.3, respectively, while the P/E for the MSCI Asia is 12.3 and 10.8 (see "From Laggard to Leader").

Corporate earnings are expected to grow 11% in Europe this year, compared with 10% in the U.S., despite Europe's outlook for anemic economic growth in 2013. But Michael Hood, global market strategist at JPMorgan Asset Management in New York, says there's reason to be cautious. "You have to bear in mind that, at best, this is going to be a slow-growing region," he says.

It might be simplistic to say that Europe is three years behind the U.S. in the market cycle, but that's how it looks. And it isn't fair to lay blame at the doors of the ECB, because Europe's troubles were different from the U.S. woes. The banking industry's funding problems fueled smoldering fears about the sustainability of some European countries' levels of sovereign debt. Investors pulled capital from vulnerable nations, which saw their borrowing costs soar and access to credit markets slowly denied. Stock markets tilted violently on rumors and worries.

Ireland, Portugal, and Greece required international bailouts. Austerity became the watchword in the corridors of power across Europe, but it was particularly unpopular in Athens, where citizens took to the streets to protest cuts in pay, employment, and pensions. Market sentiment deteriorated as investors speculated on the possibility that the euro-zone experiment was doomed.

The ECB reduced interest rates, implemented innovative programs, and demanded more action from politicians, but nothing really worked until Draghi spoke out last summer.

The pain across Europe was spread unevenly. Spanish stocks have gained only about 20% and Italy about 24% from their post-2007 lows. Investors remain unpersuaded by their efforts at reform, and doubts linger about Italy's political commitment, illustrated by last week's election stalemate.

Aided by labor reforms, German industry ran in high gear, churning out goods for export. The strength of Europe's single largest economy enabled it to foot part of the bill to rescue the euro zone's laggards. German stocks have almost kept pace with the Dow, more than doubling from their 2009 low. Frankfurt's benchmark DAX index soared almost 30% in 2012, although it has labored since the start of 2013.

Utilities have performed worst among the industries of the Stoxx Europe 600, falling 26% in the past three years. Financials gained 21% in that time, even though banks shed 21%. Personal and household goods climbed 46%, driven by a 67% jump in automobiles and parts.